Tobold's Blog
Thursday, August 13, 2009
Basics of real world economics

Not a game post.

Many people believe that economics is a highly complicated science which is hard to understand. But in reality economics is like any other science: It has some very easy to understand basics, which were discovered hundreds of years ago, and are now taken for granted by the scientists. And then there are the modern bells and whistles, going into minute details, and obscuring the layman's view on the basics. In consequence today most people believe that the current financial crisis was an unforeseen consequence of complicated financial wizardry, and that it is unclear what lies ahead. But that is not correct: What was unforeseen then, and is unknown now, is just details. Nobody knew when exactly the financial crisis would strike, which banks would go under, and nobody knows how long the current recession will last, and what other companies will go bankrupt until it ends. But just looking at the fundamentals it was clear years ago that some sort of crash was coming, and it is clear now how the long-term future will look.

Economics get extremely easy to understand if you just forget about money. Then it becomes very clear that on the one side of the economy there is consumption, people consuming goods like TVs, and services like haircuts. And on the other side of the economy there is production, workers producing TVs, and barbers providing haircuts. And the fundamental truth is that consumption can not be higher than production. You can't get more TVs or haircuts than there are TVs produced and haircuts provided. In the case of services, haircuts in our example, it also is clear that there can't be more haircuts provided than consumed. In the case of goods there can be more TVs produced than consumed, but not for long, because soon you'd have warehouses full of TVs nobody wants. So overall consumption is always equal to, or slightly lower than, production. Worldwide.

Money is just a tool which allows people to exchange work. The barber sells hundred haircuts for $10 each, then buys one TV for $1,000 with the money. If there was no money, the barber would have to persuade the hundred people involved in building a TV to each receive one haircut in barter exchange for them producing a TV for him. That only works in extremely simple economies. So people basically agreed that money was a token of work provided. You agree to accept money for your work instead of payment in goods, because everybody agrees that money has a worth, and will accept money in exchange for their goods and services. Money in itself has no worth, it is only that agreement to accept it for goods and services that makes money have value.

Money not only eases exchange of goods and services, it also allows you to store wealth by saving, or to temporarily consume more than you produce by borrowing. Taking on debt is a simple promise that while you consume more than you produce now, you will consume less than you produce in the future, and with the excess pay back the debt plus some interest. But whatever complicated form this debt takes, sub-prime mortgages, collateralized debt obligations, or what else, this doesn't change the fundamentals of economics: Consumption can not be higher than production.

What happened over the last decades was that the people in some countries, most notably the US, continuously consumed more than they produced. And other countries, like China, produced more than they consumed. Everybody either knew that, or could at least have known it, as it was printed in many a newspaper, magazine, or all over the internet. And many people with knowledge of basic economics repeatedly pointed out that this was unsustainable. At some point you have to stop consuming more than you produce, and reduce your consumption to below the value of what you produce, to pay back your debt. Many people also pointed out that cheap debt not only lead to people consuming more than they produced, it also lead to them borrowing money to invest into assets, on the mistaken belief that the value of these assets would continuously go up, so the debt would repay itself. Again everybody knew, or could have known, that this was not sustainable.

The actual surprise of the current financial and economic crisis is not that it happened, but that it happened so late. Many people had assumed the system to crash a lot earlier, which actually might have been better than letting instabilities build up further. And of course nobody could foresee the actual exact sequence of events, which is why even people aware of the problem lost money.

Looking at the fundamentals, the course of action to take is extremely simple: Americans need to consume less or produce more, Chinese need to produce less or consume more. Unfortunately it isn't obvious how the US could suddenly produce much more in goods and services, so a reduction in consumption seems inevitable. Nobody likes to reduce his consumption. It has repeatedly been shown that happiness is not a consequence of the wealth that you actually have, but a consequence of you feeling that you get wealthier, consuming more. Consuming less also means consuming different things, because you'll not cut your consumption evenly when you have to. Luxury stuff like massage chairs go first, while you'd cut food consumption only in the gravest circumstances. But that means that an abrupt change in consumption behavior means the workers previously busy producing massage chairs are unemployed, earn leass, thus can consume even less, and the whole economy spirals into a recession.

Thus to fight the recession, governments all over the world are now doing exactly that what got their economies into trouble in the first place: Taking on debt, and making money available cheaply by lowering interest rates. Again everybody knows that this is unsustainable, but it is meant as a temporary measure to smooth out the economic cycle, so that the economy is not dropping of a cliff with painful consequences. The inevitable point at which overall consumption has to be reduced to be less than production is postponed, debt builds up further. The national debt clock of the US shows an overall national debt of over 11 trillion dollars, or $38,000 per US citizen, and is growing every day.

Now sooner or later the Chinese, and other creditor countries, will want their money back. Many people lament how this will take forever, and the current generation will leave a huge load of debt to the next generation, if not generations. But this assumes a constant value of money, and a willingness in the future of people to consume less and work more. It is not certain that this will happen, because it would be extremely painful. There is another way to pay back the debt, which is basically cheating the creditors, and thus a lot less painful to the debtors: Inflation.

While everyone pretends they are against inflation, inflation is actually not universally bad for everybody. Inflation is good for people with debt, because the value of their debt decreases without them having to do anything. Inflation is neutral to people who work and spend their earnings, because wages go up roughly in step with price increases. Inflation is extremely bad for people who have money, because it decreases their wealth.

Inflation happens if the government prints more money than there is value produced by their economy. Imagine the US government starts their printing presses and prints 11 trillion dollars, using them to pay back all the national debt. This is possible, because the debt is in dollars, not a foreign currency. So suddenly all the debt is gone, but there is a lot more money around. And as explained earlier, money hasn't got inherent value, it is only a token for real wealth and work. With more dollars around, but the amount of stuff that can be bought being unchanged, the value of the dollar falls, and everything just gets more expensive. Legally the creditors have been paid back, but the dollars they received now are worth less than the dollars they originally lended out.

Of course this won't happen as obviously as I described. The US will not print 11 trillion dollars at once, load it into a container ship, and send it to China. But it is extremely likely that this is a process that will happen slowly, and gradually. A bit of simple math shows you that just 7% of inflation means your debt or your wealth halves in value in 10 years. Inflation is a hidden form of redistribution, from creditors to debtors. If you have a fixed rate mortgage, inflation is higher than the mortgage rate, and your earnings raise in line with inflation, your mortgage is basically paying itself, while whoever lended you that money is losing out.

Of course inflation has its negative sides too. The next time you want to buy something from another country, for example oil, you'll find that it will be a lot more expensive, as the value of your currency has diminished. And the next time you want to borrow money, you'll find the creditor wants a higher interest rate, or insists you borrow the money in a stable currency you can't print yourself. But overall, printing money and having some inflation is going to be a lot less painful for the US than the alternative of reducing consumption a lot. Which is why it is quite likely that inflation will happen. It is just basic economic fundamentals. Again, nobody knows when and at what rate this will happen, and the exact details. But just as people knew or could have known the basics of how we got into the economic crisis, the most likely way out is also known. Just don't believe the people who in a couple of years will tell you they have no idea why suddenly inflation like in the 70's is back, when it appeared to have been conquered in the 90's.
Yesterday i heard someone say on a business TV show: right now the government is pushing the car along the road, but the tank remains empty. I have zero faith in so called "solutions" coming from the government. By definition nothing they do adds real value, it is all artificial (like printing money).

Imho there are still several economic bubbles which will burst sometime in the future, for example the (subsidized) housing market in my country. If you live in a country with (overly) generous social services (like where i live) you will probably see a slow but inevitable collapse of those systems: the necessary support for the (redistribution of wealth) systems among those paying the (ever increasing) bills is disappearing *fast* and the whole setup causes the labor market to lack any form of flexibility.

Since we are basically (and increasingly) unable to sustain the amount of people on the planet with current production methods and available raw materials and fuels, we have much to look forward to...Refering to the Chinese curse: we live in interesting times indeed.

Regarding your remarks on higher inflation: drastically decreased consumer demand may keep that under control (for now).
A surprisingly clear piece of work. Especially the trick to remove the mony form the equation and think in terms that actually matter is a very good one - and one I used very often in the past to explain macroeconomic principles.

Unfortunately it only works so far and in the end you have to acknowledge that, if people desire money (however unreasonable that might be - they should desire the things you can buy with money), money itself becomes a good and cannot be overlooked - especially not in the short-run.

I'd also like to point out that economics is more like a religion than like a science noadays. Read Paul Krugmans Blog or other nobel prize economists. They sometimes disagree on very basic matters.

Still, thanks for the clear explanations. For everybody interested in this I can only recommend
"The Truth about markets" by John Kay or Tim Harfords "The Undercover Economist". Just to mention two great books.
As far as I'm concerned, government not blowing money they don't have is the best solution.

Most peoples wages will never keep up with 7% inflation, hell, it won't even keep up with 2 or 3%. Anyone with sense knows that the US has some bad years coming; just it'll be courtesy of our government instead of banks.

The part that amazes me is that China is even remotely willing to loan our government anything anymore. It seems like they would know the inevitable result of us slowly devaluing our currency to pay them off.
Thank you Tobold.

I finally understood what is inflation.

Seems our beloved leaders always seem to pass the message with too much noise to be understood.

But now I also understand why some EU countries old governors say that the central EU bank, even if it's giving out money to less rich countries (like mine, I'm from Portugal, and no, I don't like that my country depends on it so much) is having a pernicious effect by then strangling them in economic straitjacket and won't allow countries to use inflation as a tool to reduce debt.

Seems like we are headed to the bad side of an eventual United States of Europe.

Great Post Tobold
It's fun to come back here often, as it's not just a gaming blog. After reading your quality posts, I decided it's better for me to stop blogging in English.

This is absolutely superb work. I hope you don't mind that I have re-posted it to our own internal intranet forum at work as I think it offers a remarkably clear explanation of our economic woes (I have of course cited and linked back to here as the source).

Your reasoning and writing is very clear and I'd like to see more articles like this please.

But now I also understand why some EU countries old governors say that the central EU bank, even if it's giving out money to less rich countries (like mine, I'm from Portugal, and no, I don't like that my country depends on it so much) is having a pernicious effect by then strangling them in economic straitjacket and won't allow countries to use inflation as a tool to reduce debt.

Seems like we are headed to the bad side of an eventual United States of Europe.

A few hundred years ago the dominating tax was the inflation tax. The king would just print the coins he needed. If gold was rare he used other metals. There were other taxes - but they were completely dominated by the inflation tax.

This system has worked and would still work - but its performance is abyssmal.

Since the government has no reason to not just print the money it spends and spends and spends .. to be reellected or to build more palaces.

If I were you I'd be happy that Portugal cannot pint the money. I wished that nobody could print it, but unfortunately it has to be printed by somebody - who should be as independent as possible.

High inflation or even hyperinflation kill an economy. Look at Zimbabwe, the third Reich or Iran, right now.

All long-term successful economies in mankinds history relied on a stable currency with a low inflation of 1% to 5%; no more, no less, because deflation is even worse. But that's another topic ;)
"Of course inflation has its negative sides too. The next time you want to buy something from another country, for example oil, you'll find that it will be a lot more expensive, as the value of your currency has diminished."
On the flip side, a weaker currency means people are more likely to buy our goods; that's part of how China has been driving its economic boom, with an artificially weak currency.

@Phantasmagoria: Saying "by definition" before making random claims does not make them true. The size of the money supply is actually very real and has real effects.
This post really shows how simple economics should be. Unfortunately this is not reality. The US. is a fractional reserve system. The banks have a deposit with the FED, a small percentage of the money they loan out to the people. The actual money they loan out to the people is made out of thin air. The money isn't printed because 90% of our money is digital. Basically this means our banking system is actual creating new money. This new money is loaned out and is expected to be repaid, minus the fact the money for the interest was not created.

New debt means we need need new goods and services to pay the debt. We can never as a society pay back what was lent out because the banks didn't create the interest. This results in more debt to pay off the previous debt. Now more goods and services are needed. New goods and services require more resources. This continues exponentially.

We will make it through the bubble and bursts of economy no problem. The end result is that we will never repay our debt. Eventually we will use more resources then the earth has, which is actually impossible because resources are real where as money, value, and debt are all fake. This will most likely lead to a huge war when we finally start running out of resources.

Not to mention that our monetary system creates a society that is constantly competing with each other to aquire more money, when the reality is that if we all consumed what we needed there would be plenty of resources to go around. Technology today can do wonders, there is no need for me and my wife to be working 50 hour weeks in comparison to my father working a 40 week for our family. Considering all of our advancements in technology we should be working less.
As others have said, a very clear and well written piece. It will indeed be interesting to see how far the current recovery goes, and when inflation starts to really kick in. Knowing it will happen is one thing, predicting WHEN it will happen is where the money is made.
I wish you were my economics professor in college. This is so much clearer than that horrible book they made us read.
The size of the money supply is actually very real and has real effects.

The size of the money pool has actually almost no effect. A few years ago Germany halved all Deutsche Mark and called it Euro - no effect occured.
No effect occured either when Zimbabwe just eliminated another 9 zeros on its $ a few months agro.

Of interest is the expected change in value vs. the real change in value.

And this is, btw, not an easy topic at all. Probably not even a real science - more like a social science with no or only bad mathematical models.

Not to mention that our monetary system creates a society that is constantly competing with each other to aquire more money, when the reality is that if we all consumed what we needed there would be plenty of resources to go around. Technology today can do wonders, there is no need for me and my wife to be working 50 hour weeks in comparison to my father working a 40 week for our family. Considering all of our advancements in technology we should be working less.

There is some - limited - truth to this. You manage to demonstrate, however, how incomplete the publics knowledge of or economic system really is.

And these people are asked to vote every few years.

Nothing lasts forever - and our political/economic system is no exception. But so far it wasn't that bad, was it? Compare our lives with those of your grandparents or even inhabitants of third world countries.
Great post, i never looked at inflation that way and it does suggest why the UK government is printing money at the moment. After takeing a pay cut, no pay rise this year then going to a 4 day week, high inflation is not something im going to look forward to. Might also suggest a reason for house price rises weve seen recently.
The trick is to realize that money itself becomes a commodity and debt behaves like an "option" on a commodity. Debt is money borrowed from the future, and that's how interest rates and confidence levels affect the value of money (present value as a commodity).

The road out of financial crises has always been the same -- tighten your belts! but no one wants to stop the gravy train -- and no one wants to lower their expectations. Big business and governments want to keep people spending, not saving. Otherwise the rich won't stay rich for very long.

The present plan to pump public debt into an already exhausted price-debt model will only buy us some time and defer what will be an even bigger correction. ie. Collapse.
I strongly disagree, Tobold. Wealth has no geographic boundaries.

Whoever has the wealth, can consume more regardless of where it's produced. Where something is produced is simply a function of cost and a competitive market.

I'm not saying that China or the balance of trade is not a concern for the US, but what I am saying is that it's not the SOURCE of our current economic trouble.

The real source is in the real estate and financial markets.

When my father bought his home, the traditional expectation is that the price of your home would stay fairly flat (relative to inflation).

The idea being that you are buying a deprecating asset (the building) that will become devalued as it gets older. The land may increase, but the building is decreasing.

Today, the expectation is that your home will be worth significantly more in the future than it did when you bought it. Even over the short term. And it was an expectation that seemed justified as it was fueled by home prices that were increasing.

But why did they increase? Greater demand due to population or something else?

Lower interest rates is a major cause (and here you can blame the FED). A lower rate means that more buying power. Someone who could afford a $250,000 house with an 8% rate could afford a $400,000 house with a 6% rate.

The economy starting to stall a bit? Let's lower the rate again. But, in the end, you can only lower something so much until you have to raise it again.

And also consider that more woman are working mothers, which means a dual income. And with all this extra income, what can the family afford? A more expensive house.

But the big problem is that instead of having a bit of sanity about the rising home prices, banks and investors bought into the trend.

Worse, they came up with things like derivatives that COUNTED on the prices continuing to rise.

So when interest rates finally DID come up, what happened?

New buyers couldn't afford to pay what previous buyers had paid. And the whole house of cards came crashing down around us.

Explains the credit crisis rather well. Not everything, and not perfectly, but well enough for non-economists to understand.
BTW, I agree with most of what you said in the second of half of the blog entry about inflation.

However, I do think your making inflation out to be a neutral thing for the middle class and a bad thing for the rich which is incorrect.

Wages often DON'T beat inflation. Which makes it harder for the working guy to keep up with his standard of living.

And unless the rich have their money buried in the backyard, the majority of their wealth is safe in investments that likely DO beat inflation. Which means that it doesn't really devalue their wealth at all.

Also, slightly off-topic, but one thing that's often misunderstood is that having a large national debt is not an entirely bad thing.

In the late 80 and early 90s, the Japanese suffered a major crisis because their Yen was valued so much higher than the US dollar.

It made them a terrible import partner, but an excellent export partner. Meaning that goods made in Japan were expensive, while goods shipped to Japan could fetch huge profits. This is a big reason why Japan has so many trade barriers to prevent foreign competition.

The US had the same problem with Mexico, China, and the other developing countries where goods could be produced cheaply.

A national debt actually works as a balancing mechanism in the flow of trade. As the value of our dollar decreases, foreign goods may increase in price which allow our local producers to remain (or become) competitive in the marketplace.

Personally, I think we should have been a lot more protectionist about our balance of trade and had a lot more trade barriers. As you say, China produces a ton of goods for the US and while we see short-term gains in lower prices, it's bad for us long-term as we lose our jobs and ability to support ourselves.
Nice article.

Inflation benefits those who have earliest access to the money, since they get full purchasing power out of the money before it filters through the system. It's useful, but it's not something that benefits those trying to keep their own consumption and production balance on the side of production rather than consumption.

(Speaking of which, I think you've got a typo at the end of the second paragraph, using "consumption" twice the way you do.)

You're right, though, this is exceedingly simple math. Produce more than you consume, and the worst you have is waste and some deflation. Consume more than you produce, especially in the magnitude possible generated by exponentially increasing debt interest, and the system is absolutely unsustainable. If you can understand addition and subtraction, you can understand the production/consumption equation, and if you can understand exponential growth and the nature of "finite" and "infinite" and how they collide, and you can understand how the system *will* crash at some point.

It's fifth grade math.

The alphabet soup of financial "weapons of mass destruction", politics and "economic education" in general are engineered not for clarity for the consumer, but to obfuscate the simplicities as well as possible, the better to profit from manufactured ignorance.

The simple truth is that if you consume more than you produce, you will have (and cause) trouble. There's no way around that elementary school math.
Thanks Tobold that was an extremely clear and well written post.

However, you write as if consumption in the US hasn't changed. In fact, it dropped off a cliff. The savings rate in the US went from zero right before the crisis to nearly 10 percent (where it was all the way back in the 1980's) Our economy is the middle of a lurching realignment to accommodate that fact.
The simple truth is that if you consume more than you produce, you will have (and cause) trouble.

The problem I have with this statement is how it all ties back to the "national debt" and inflation. The logic that you and Tolbold both present is that production vs. consumption is the CAUSE of the problem, when it is actually just the inevitable outcome or currency valuation in a free market.

Let's say that I pay foreign labor $500 to produce something that with local labor would cost me $900. By importing the item, I can sell it for $1200 in my local market and profit an additional $500. The downside to my venture is that $500 went to a foreign market instead of presumably to my local economy.

Now let's say that the value of our dollar drops by half relative to the foreign market. What once cost me $500 to import will now cost me $1000. Since I can buy it locally for $900, there is no longer an incentive for me to import the item.

Ironically, the very thing that bothers you (consumption greater than production) actually starts to reverse itself by the devaluation of your dollar. Meanwhile, the exact opposite effect is felt in the foreign market as their currency raises in value relative to ours. In fact, the valuation of the US dollar versus other markets is exactly the reason WHY we consume more than we produce.

Basically, this is what amounts to the modern version of colonialism. We use the colony to produce the item, we benefit from the lower costs in the short-term, the colony eventually becomes self-sustaining and negotiates a much more favorable position as an equal (or greater) partner.

From a US perspective, the real culprit in this balance of power is the free market. Without trade barriers, the only way to maintain a higher standard of living is to produce things that are of much higher value. That way, the overall production of actual items might be less but the monetary value of what is produced is greater.

For years, our leaders told us this was the way of the future and when the blue collar jobs went overseas, the answer was retraining to jobs that required a highly trained workforce like software development. Of course now, 20+ years later, we are seeing those jobs being outsourced to developing countries like India with a white collar workforce.

The best alternative in my mind is stronger trade barriers. Yes, it is protectionist, but unless we can somehow keep technologically ahead of the curve, the balance of power is going to continue to shift to developing countries.
Nice post.

Following on from what you said about it. Money is not real and can be made and destroyed. This is a key concept to really understanding wealth generation.

"It has repeatedly been shown that happiness is not a consequence of the wealth that you actually have, but a consequence of you feeling that you get wealthier, consuming more"

I don't think this has been shown to be the case. I believe the magic answer to happiness is starting to include far more commponents like health, strong family and friend relationships and spiritual well-being and less and less money/consumption. I believe that more money is making people somewhat happier up until they are middle or perhaps upper-middle class but beyond that adds little happiness.

re:Inflation - i'm pretty sure i've read a few times that US wages are generally not keeping up with inflation. Thus the statement that real wages have declined since about the 1950's.

Great post though.

Gobble gobble.
you can't just "forget about money". for the past decade the US has been printing money like we were running out of trees. Combined with trying to promote home ownership, which ended up haveing people be leveraged by far more than they should have been.

The recent problems are a vindication of Freidman and monetary policy. We ignored it, and now it's come to bite us.

Last year people kept saying the problems showed Friedman was wrong and Keynes was right, but that assumes the US was actually following monetary police, which it was not.

The size of the money supply has everything to do with it.
I don't see this at all. The financial crisis had zero to do with general economic theory, and all to do with many specific little actions that compounded into a whole, like how financial entities structured risk, or the popularity of "house flipping" as a means to generate wealth and it's viral spread.

Honestly, when have professors of economics actually predicted anything, instead of trying to make theories from hindsight? You are pretty flippant about dismissing details, but details drive the economy, not abstract theories. If businesses had realized how they were exposed to risk through derivatives and other forms of paper accounting,and just did the due dilligence they do with other investments, they could have contained the crisis and it wouldn't have spread to healthy, productive companies and people.

If people had looked at actual data, they would have known right away where there was danger, same as the dot-com crash. Ignoring the details is what gets you in trouble.
High inflation ("like the 70's") is not inevitable. The reason it has not happened now is because a) the banks the Fed has lent to are not spending the money because they are being cautious and are also trying to offset massive losses (and don't know where to invest) and b) the threat now is deflation, so it will take some time for it to turn around to inflation in the first place.

Once the economy recovers, all that extra cash will obviously be looking for a place to go. This is where, if properly done, a rise in interest rates can make the reinvestment happened at a gradual and controlled rate, rather than flooding in. If this is done in a timely fashion, there is no need to over-adjust with very high interest rates.

Also, as another poster mentioned, when you have cash in a high inflation situation, there is very likely to be high interest rates or great investment opportunities.

Although the savings rate of US consumers is important, there are also a myriad of terrible higly risky decisions that were made by investment banks, many who had in fact convinced themselves that they weren't taking on that much risk at all. They were flush with money and started taking big gambles, gambles so big the entire economy would go down if they lost. And they did.

Finally, although I don't think you really suggested otherwise Tobold, it's important not to retract government spending when on the verge of a depression (as the US was); it is precisely when the corporate and private world suddenly start to grasp onto their money as tightly as possible when the government has to step in to fill the spending gap, thus keeping the economy from crashing even harder than it already has.
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